Macroeconomics - Cengage Learning

C H A P T E R 

21 

The Influence of Monetary and 

Fiscal Policy on Aggregate Demand 

P R I N C I P L E S O F 

Macroeconomics 

N. Gregory Mankiw 

Premium PowerPoint Slides 

by Ron Cronovich 

© 2010 South-Western, a part of Cengage Learning, all rights reserved 

2010 

update 

In this chapter, 

look for the answers to these questions: 

How does the interest-rate effect help explain the 

slope of the aggregate-demand curve? 

How can the central bank use monetary policy to 

shift the AD curve? 

In what two ways does fiscal policy affect aggregate 

demand? 

What are the arguments for and against 

using policy to try to stabilize the economy? 

Introduction 

Earlier chapters covered: 

the long-run effects of fiscal policy 

on interest rates, investment, economic growth 

the long-run effects of monetary policy 

on the price level and inflation rate 

This chapter focuses on 

THE INFLUENCE OF MONETARY AND FISCAL POLICY 

1 

2 

1

Aggregate Demand 

Recall, the AD curve slopes downward for three 

reasons: 

The wealth effect 

The interest-rate effect 

The exchange-rate effect 

Next: 

A supply-demand model that helps explain the 

interest-rate effect and how monetary policy 

affects aggregate demand. 


The Theory of Liquidity Preference 

A simple theory of the interest rate (denoted r) 

r adjusts to balance 

Money supply: 


The Theory of Liquidity Preference 

Money demand 

For simplicity, suppose household wealth 

includes only two assets: 

Money – liquid but pays no interest 

Bonds – pay interest but not as liquid 

A household’s “money demand” reflects its 

preference for liquidity. 

The variables that influence money demand: 


3 

4 

5 

2

Money Demand 

Suppose real income (Y) rises. Other things 

equal, what happens to money demand? 

If Y rises: 

I.e., an increase in Y causes an increase in 

money demand, other things equal. 


A C T I V E L E A R N I N G 1 

The determinants of money demand 

A. Suppose r rises, but Y and P are unchanged. 

What happens to money demand? 

B. Suppose P rises, but Y and r are unchanged. 

What happens to money demand? 


Answers 

6 

7 

8 

3

Interest 

rate 


Interest 

rate 

How r Is Determined 

M 

MS curve 

MD curve 

How the Interest-Rate Effect Works 

r 1 

MS 

MD 1 


M 

P 

AD 

Monetary Policy and Aggregate Demand 

To achieve macroeconomic goals, the Fed can 

use monetary policy to 

P 1 

P 2 

The Fed’s policy instrument is 

The news often reports that the Fed targets the 

interest rate. 

More precisely, 

To change the interest rate 


Y 1 

Y 

10 

11 

12 

4

The Effects of Reducing the Money Supply 

Interest 

rate 

r 1 

MS 1 

MD 


M 


Monetary policy 

For each of the events below, 

- determine the short-run effects on output 

- determine how the Fed should adjust the money 

supply and interest rates to stabilize output 

A. Congress tries to balance the budget by cutting 

govt spending. 

B. A stock market boom increases household 

wealth. 

P 1 

C. War breaks out in the Middle East, 

causing oil prices to soar. 


Answers 

P 

Y 1 

AD 1 

Y 

13 

14 

15 

5

Fiscal Policy and Aggregate Demand 

Fiscal policy: 

Expansionary fiscal policy 

Contractionary fiscal policy 

Fiscal policy has two effects on AD... 


1. The Multiplier Effect 

If the govt buys $20b of planes from Boeing, 

Boeing’s revenue increases by $20b. 

This is distributed to Boeing’s workers (as wages) 

and owners (as profits or stock dividends). 

These people are also consumers 

Multiplier effect: 


A $20b increase in G 

initially shifts AD 

to the right by $20b. 

The increase in Y 

causes 

1. The Multiplier Effect 

P 1 


P 

AD 1 

Y 1 

Y 

18 

19 

20 

6

Marginal Propensity to Consume 

How big is the multiplier effect? 

It depends on 

Marginal propensity to consume (MPC): 

E.g., if MPC = 0.8 and income rises $100, 

C rises $________ 


A Formula for the Multiplier 

Notation: G is the change in G, 

Y and C are the ultimate changes in Y and C 

Y = C + I + G + NX identity 


I and NX do not change 

because C = MPC Y 

solved for Y 

A Formula for the Multiplier 

The size of the multiplier depends on MPC. 

E.g., if MPC = 0.5 multiplier = 

if MPC = 0.75 multiplier = 

if MPC = 0.9 multiplier = 

1 

Y = G 

1 – MPC 

The multiplier 


A bigger MPC means 

21 

22 

23 

7

Other Applications of the Multiplier Effect 

The multiplier effect: 

Each $1 increase in G can generate 

more than a $1 increase in agg demand. 

Also true for the other components of GDP. 

Example: 


2. The Crowding-Out Effect 

Fiscal policy has another effect on AD 

that works in the opposite direction. 

A fiscal expansion raises r, 

So, the size of the AD shift may be ___________ 

than the initial fiscal expansion. 

This is called the crowding-out effect. 


How the Crowding-Out Effect Works 

Interest 

rate 

A $20b increase in G 

r 1 

MS 

MD 1 


M 

P 1 

P 

AD 1 

Y 1 

Y 

24 

25 

26 

8

Changes in Taxes 

A tax cut increases households’ take-home pay. 

Households 

The size of the shift is affected by the multiplier 

and crowding-out effects. 

Another factor: whether households perceive the 

tax cut to be 



Exercise 

The economy is in recession. 

Shifting the AD curve rightward by $200b 

would end the recession. 

A. If MPC = .8 and there is no crowding out, 

how much should Congress increase G 

to end the recession? 

B. If there is crowding out, will Congress need to 

increase G more or less than this amount? 


Answers 

27 

28 

29 

9

Fiscal Policy and Aggregate Supply 

Most economists believe the short-run effects of 

fiscal policy mainly work through agg demand. 

But 

Recall one of the Ten Principles from Chap 1: 

People respond to incentives. 

 

People who believe this effect is large are called 


Fiscal Policy and Aggregate Supply 

Govt purchases might affect agg supply. 

Example: 

This effect is probably more relevant in the long 

run: it takes time to build the new roads and put 

them into use. 


Using Policy to Stabilize the Economy 

Since the Employment Act of 1946, economic 

stabilization has been a goal of U.S. policy. 

Economists debate how active a role the govt 

should take to stabilize the economy. 


31 

32 

33 

10

The Case for Active Stabilization Policy 

Keynes: 

among households and firms, leading to shifts in 

aggregate demand and fluctuations in output and 

employment. 

Also, other factors cause fluctuations, e.g., 

If policymakers do nothing, these fluctuations are 

destabilizing to businesses, workers, consumers. 


The Case for Active Stabilization Policy 

Proponents of active stabilization policy 

believe the govt should use policy 

to reduce these fluctuations: 

When GDP falls below its natural rate, 

When GDP rises above its natural rate, 


Keynesians in the White House 

1961: 

John F Kennedy pushed for a 

tax cut to stimulate agg demand. 

Several of his economic advisors 

were followers of Keynes. 

2001: 

George W Bush pushed for a 

tax cut that helped the economy 

recover from a recession that 

had just begun. 


34 

35 

36 

11

The Case Against Active Stabilization Policy 

Monetary policy 

Firms make investment plans in advance, 

so 

Most economists believe it takes at least 

____________ for mon policy to affect output 

and employment. 

Fiscal policy 

Changes in G and T require Acts of Congress. 

The legislative process can take months or 

years. 


The Case Against Active Stabilization Policy 

Due to these long lags, critics of active policy 

argue that 

These critics contend that policymakers should 

focus on long-run goals like economic growth 

and low inflation. 


Automatic Stabilizers 

Automatic stabilizers: 


37 

38 

39 

12

Automatic Stabilizers: Examples 

The tax system 

Govt spending 

 

Govt spending on these programs automatically 

rises, which stimulates agg demand. 


CONCLUSION 

Policymakers need to consider all the effects of 

their actions. For example, 

When Congress cuts taxes, it should consider 

When the Fed reduces the rate of money 

growth, it must take into account not only 


40 

41 

13

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